A NEW benchmark interest rate Chinese banks will need to use to set lending rates will be linked to the central bank’s medium-term liquidity facility, a People’s Bank of China policy adviser said yesterday.

The central bank unveiled a key interest rate reform Saturday to help steer borrowing costs lower for companies and support a slowing economy that has been hurt by a trade dispute with the United States.

“Through the reform, it is clearly required that the banks’ lending rates should be linked to the LPR (loan prime rate), and the LPR should be linked to the MLF (medium-term lending facility) interest rate, thus establishing a relatively smooth transmission mechanism,” Ma Jun said.

“In the future, if the policy interest rate falls, the loan interest rate will also fall, which will help to reduce the financing cost of enterprises.”

Under the central bank’s changes, banks must set rates on new loans using the new LPR as the benchmark for floating lending rates rather than the central bank’s benchmark bank lending rate.

The central bank launched the LPR in 2013 to reflect rates that banks charge their best clients. But the LPR has been reacting little to market demand and supply, with the one-year rate currently at 4.31 percent, versus benchmark one-year lending rate of 4.35 percent.

Ma said the LPR reform will help it better reflect changes in market rates and help lower corporate funding costs.

The central bank said it will improve the mechanism used to establish the LPR from this month, in a move to further cut real interest rates for companies as part of broader market reforms.

Chinese banks’ new LPR quotations will be based on open market operations, the central bank said over the weekend. The national interbank funding center will publish the reference rate from tomorrow and on the 20th day of each month thereafter.

Banks will set rates on new loans by adding a spread to the new LPR reference rate, the central bank said.

But existing loans will still follow the original contracts that were signed in line with the benchmark lending rate. China’s outstanding local-currency loans were at 147 trillion yuan (US$20.87 trillion) at the end of July.

A massive 28 trillion yuan in long-term mortgage loans are exempt from the new program, analysts at Nomura note.

The market’s focus will be on where the new LPR is set.

Analysts believe the central bank could cut the one-year interest rate on the MLF, which stands at 3.3 percent, in order to guide borrowing costs lower.

Analysts say the new LPR rate will be lower than the current level, but they are divided over the scope of reductions on borrowing costs for firms.

Ming Ming, head of fixed income research at CITIC Securities in Beijing, said he expects the first new rate will be set lower to narrow the yield gap between LPR and interest rate on the MLF. That gap is currently 101 bps.

A batch of one-year MLFs with a value of 149 billion yuan (US$21.15 billion) is set to expire next Monday.

“We see chances for China to lower its MLF rate in the coming months,” said Tommy Xie, economist at OCBC Bank.

“However, we don’t see the urgency for China to cut its MLF rate in August as China may want to take a wait-and-see approach to see how markets react and digest the latest reform.”

Xie said the move is a “half step” towards interest rate liberalization, and the link to the medium-term lending rate may only be temporary.

“The current rate liberalization focuses only on the lending rate while the deposit rate was left untouched. ... In the longer run, China may also need to loosen the setting of deposit rate.”

(SD-Agencies)